Here is our talk from the CryptoFin Conference from October 2019 in Tallinn about how to disintermediate the banks: Here is the short summary. We need: More tokenization Crypto credit-money...
Here is our talk from the CryptoFin Conference from October 2019 in Tallinn about how to disintermediate the banks:
Here is the short summary. We need:
Wealth management is a multi-billion-dollar business. As the market capitalization for cryptoassets grows, it will be interesting to apply the concepts of wealth management to cryptocurrency investments. This article looks...
Wealth management is a multi-billion-dollar business. As the market capitalization for cryptoassets grows, it will be interesting to apply the concepts of wealth management to cryptocurrency investments.
This article looks at how the traditional wealth management industry works, covering the following areas:
Portfolio management theory
Strategic and tactical asset allocation
Client risk profile
Portfolio construction
Next, we will synthesize our approach to apply modern portfolio management practices to cryptoassets.
Portfolio Management Theory
The key principles of portfolio management theory are as follows:
It is assumed that higher potential returns are associated with higher risk and vice versa.
Assets are to be diversified, such that the volatility of various assets balance each other out, allowing investors to achieve the best return for the chosen risk level.
Different types of assets have different characteristics:
Expected historical return — for example, equities have higher returns than bonds.
Expected risk (volatility) — for example, equities have higher volatility than bonds.
Correlation with other assets — different correlations mean that asset classes move in different directions during the same market events. For example, equity performance has a medium correlation with bonds, but an even lower correlation with alternative assets.
So, the basic idea is to combine different assets in order to:
Reduce expected portfolio volatility
Optimize expected return for the chosen risk level
Efficient Frontier
Strategic and Tactical Asset Allocation
The overarching asset classes in traditional portfolio management are:
Equities
Bonds
Real estate
Alternative investments
Each of the asset classes has its own characteristic return; in the long run, equities have the highest return, then bonds, followed by real estate. Alternative investments exhibit similar returns to equities and additionally they should correlate negatively with other assets (at least in theory). Return and risk are correlated — the higher the returns, the higher the risk. In this context, high risk implies high risk to the downside (losses in portfolio value).
Strategic asset allocation defines the asset allocation between the main asset classes. Strategic asset allocation accounts on average for 92 percent of the variation of returns over time (Brinson, Singer and Beebower).
Tactical asset allocation focuses on the asset allocation within the subcategories of the main asset classes.
For example, in the case of equities the possibilities are investing into the following subcategories:
Equities of developed countries
Equities of emerging countries
In the case of bonds, we can choose between:
Corporate bonds
Sovereign bonds
Long-duration or short-duration bonds
High-rating or low-rating bonds
If interest rates are low, then equities would perform relatively well, and larger parts of the portfolio could be allocated to equities. If the economy is in the phase of recovery, equities of developed countries have potential; the further we move into recovery, the more potential lies in emerging countries’ equities.
If interest rates are declining, it makes sense to invest in bonds — the value of bonds will increase as interest rates fall. Additionally, the longer the duration of these bonds, the higher the performance effect through the declining interest rates.
The main idea is that investors do not need to “pick stocks” or “pick bonds”. Instead, most of their portfolio performance will be delivered through strategic asset allocation and tactical asset allocation.
Client Risk Profile
Each wealth management client will have an investment policy statement comprising:
Financial objectives — what is the time horizon of the investments?
Risk profile — what risk level can and will the client accept?
Need for liquidity — what monthly/yearly liquidity needs does the client have?
Investment restrictions — do some sectors like tobacco and gambling raise ethical concerns?
Asset liability management — what is the general asset/liability situation of the client?
We assume here that the client has a multi-year time horizon, there are no monthly liquidity requirements and no investment restrictions are applied.
The client risk profile is the key determinant when constructing the client portfolio. The main factors here are:
Risk tolerance
Risk ability
Risk tolerance is determined by the client’s investment experience in years, their interest to follow market developments, and their loss sensitivity and risk awareness.
Loss sensitivity can be characterized as the way in which the client would react, for example, to the hypothetical scenario of 30-percent losses on the value of their portfolio:
Reduce all or most positions
Reduce some investment positions
Maintain current positions
Increase some positions
Increase all or most existing positions
Risk awareness is determined by the following:
Would the client prefer greater profit potential for higher underlying risk — for example, 30-percent return for 20-percent risk, or;
Would the client prefer smaller profit potential for lower underlying risk — for example, 5-percent return for 1-percent risk?
Loss sensitivity and risk awareness are determined by psychometric characteristics. In other words, how does the client deal with risk? Some clients are willing to take higher risks for the chance to receive higher rewards, but quite a lot of clients would sleep better if they faced lower risks.
Risk ability is determined by rational factors:
Time horizon — in which time horizon would the client need the assets?
Free asset ratio — what is the ratio of free assets (financial assets less bound assets) to the client’s total assets?
Annual loss compensation rate — what is the ratio of (annual income — annual expenses) / free assets?
Client risk profile indicates which level of risk the client can take. It is derived from risk tolerance and risk awareness. Both are ranked according to the following levels:
Low
Moderate
Medium
Enhanced
High
The client risk profile is the lower value of risk tolerance and risk awareness. It is the key determinant for client portfolio construction.
Portfolio Construction
Portfolio Construction
Client risk profiles are divided into five different risk levels, and a standard portfolio will be constructed for each of these risk levels.
At a higher level, cryptocurrencies can be allocated into the following sub-classes:
Bitcoin
General blockchains
Smart contract blockchains
Payments
Anonymous payments
Resource sharing (storage/compute power/network)
Prediction markets
Gaming
Fiat proxies
Standard portfolios are constructed from these sub-classes. The idea is not to have exposure to every specific cryptocurrency, but to have exposure to crypto sub-classes. Some of these sub-classes will have higher returns (and higher risks) and vice versa.
We would calculate the historical returns and volatility for each of these sub-classes and use these values as inputs as part of the standard portfolio management approach. This calculation could look as follows:
Sub Categories
The portfolios for different sub- classes could be constructed as follows:
Sub Categories Allocation
The client would have to:
Complete the questionnaire for determining their risk profile
Transfer assets to the platform
And that’s all:
Client portfolio construction will be an automated process based on the client risk profile
Portfolio adjustments will be executed automatically if sub-category ratios leave a predefined range
The client will receive regular portfolio performance reports
The client would pay a monthly or yearly fee to the platform and would be relieved from the day-to-day management of their assets. The client would be able to focus on areas that are most relevant and important to them.
Note: This article is provided for educational purposes only. For actual investment advice, always consult your professional investment advisor. The author accepts no liability for any consequences of decisions taken on the basis of the information contained in this article, nor does the author guarantee the correctness or up-to-dateness of the information contained herein despite the author’s best faith.
Additional Information
Brinson, Gary P., Brian D. Singer, and Gilbert L. Beebower. 1991. “Determinants of Portfolio Performance II: An Update.” Financial Analysts Journal, vol. 47, no. 3 (May/June): 40–48.
Tokenmarket.net lists more than 270 ICOs (many of them completed, some ongoing and many others upcoming). Some ICOs are supported by lots of PR and advertising, while others less so....
Tokenmarket.net lists more than 270 ICOs (many of them completed, some ongoing and many others upcoming). Some ICOs are supported by lots of PR and advertising, while others less so. There is certainly a “get rich quick” hype in the ICO space. How should an ICO investor decide where to invest? This article proposes an unorthodox investment approach: the lazy investment strategy. Of course, read at your discretion; this is not financial advice.
First we compare the market capitalizations after the ICO phase with current market capitalizations (based on the market capitalizations listed on coinmarketcap.com). As coinmarketcap.com does not always show the market capitalizations from the first day, in some cases these figures have to be estimated (applying the following: coin price after issuing X available supply). The current market capitalizations are indicated as at July 20th, 2017. The last column shows the growth factor — by how many multiples has the market capitalization grown since the ICO launch.
Long List
This table is not representative for all ICOs but is intended to provide a factual basis for the investment approach below.
The ICOs can be clustered into three groups:
ICOs for which the current market cap is more than 3 times the issuing price
ICOs for which the current market cap is between a factor of 1 and 3
ICOs for which the current market cap is below the issuing price
Group 1: High performers
The first group contains the ICOs with good business models, also combined with some effective PR/marketing:
High Performers
First, let’s look at the coins with good business models (in the author’s opinion). These include the following examples:
Antshares (now NEO): for issuing digital tokens. There is clear business demand for this application.
Ark: for bridging between different blockchains. There is clear business demand for this application.
Komodo: a private, untraceable coin. There is clear business demand for this application.
SingularDTV: for digital rights management. There is clear market demand for this application.
Are these coins a good investment? They already have high prices, but there is also market demand. We can short-list them and keep an eye on them during dips.
The “high performers” group also includes PR coins:
Veritaseum: There is certainly market demand for P2P financial products. However, how should this model work in real life? Let’s start with some basic questions. How are risk and collateral handled? The business plan does not answer this question.
The Veritaseum token has only one operation, “assigntoken”. It’s not clear how they would generate revenue for shareholders with only one operation in their contract?
The available supply of Veritaseum is 2 percent of total supply. The market cap of 2 percent of supply is USD 384 million; the market cap of total supply would therefore be USD 19 billion… Time for a reality check — would you invest in a business valued at USD 19 billion without a clear revenue generation scheme and in which key business case topics are not addressed?
Should one invest in Veritaseum? Short answer — No.
Lykke: This is a “decentralized exchange”, but with a central matching engine. Decentralized exchanges do not hold private keys; those stay with the clients. But, does this model justify the USD 63 million valuation of circulating supply? This translates into a total valuation of USD 317 million (approximately 20 percent of the total supply of Lykke is in circulation). What about AML (anti-money laundering) and KYC (“Know Your Client”) obligations? Could the regulator shut down this “decentralized” exchange? Actually yes, it could. All you would need to do is switch off the central matching engine…
We should also keep in mind that Bitfinex carried out an equity offering after a hack with a “post-money” valuation of USD 200 million, and Bitstamp had an equity offering with a total valuation of USD 60 million. Both of them are established exchanges with a proven ability to generate revenue, a stable client basis and functional regulatory compliance (KYC, AML, etc).
Group 2: Performers
The market cap of these coins has increased between 1 and 3 times. Some of them have clear revenue-generating business models and are therefore worth considering as investment candidates:
Performers
Group 3 — Potentials
The last group represents the coins for which the issuing price is higher than the market price.
These are the potentials. For example, NVO, Encryprotel, Mysterium, and Tokencard have clearly defined revenue-generating business models and they are valued below the issuing price:
Potentials
Lazy investment strategy
Instead of dealing with the hassle of investing in ICOs (setting up wallets, trying to submit transactions by a specific time, waiting until the coins are assigned, etc.), you could follow the “ICO pattern”:
The demand for coins and the market cap of many ICOs are high during the launch phase
The price corrects after the launch
The ICO launch phase involves a lot of marketing and PR. As emotions and excitement tend to cool off after the ICO, the question remains: What is the real value of certain ICOs? Without continued PR backing, we will likely see a price correction.
These assumptions can be used to create the following strategy:
Wait for the market correction of the ICO coin
Analyze which price-corrected coins have real revenue-generating business models
Analyze which of these price-corrected coins have an alpha product ready and their first customers using the product
The coins that pass all these test will be our investment candidates
Follow the business model and choose the entry point
Ultimately, the business model is the deciding factor:
– Is there market demand?
– Is there a clear business model?
– Does the business model have a network effect (Metcalfe’s law: the value of a network is O(n2))? If yes, the model is easily scalable. If no, it’s rather a traditional business model that may not require a blockchain.
– Does the business model have a revenue-generating scheme?
– Is the alpha software/alpha product ready? Are there initial beta customers using this product?
Note: This article is provided for educational purposes only. For actual investment advice, always consult your professional investment advisor. The author accepts no liability for any consequences of decisions taken on the basis of the information contained in this article, nor does the author guarantee the correctness or up-to-dateness of the information contained herein despite the author’s best faith.
Introduction Digital Banking is on everyone’s mind — it’s about automating end-to-end banking processes and offering a digital experience to end clients. The focus on Digital Banking is understandable —...
Digital Banking is on everyone’s mind — it’s about automating end-to-end banking processes and offering a digital experience to end clients. The focus on Digital Banking is understandable — we are all witnessing increasing cost pressures, regulatory pressures and a low-interest rate environment. Digital Banking is the answer by the traditional banking system to these pressures. However, Digital Banking per se causes little changes to the banking ecosystem: in principle banks continue as they are, just operate more effectively.
Most of us witnessed the emergence of the Internet and World Wide Web 2.0 and the new network-based business models that were born. Could the same happen with Digital Banking? Could we anticipate the emergence of Digital Banking 2.0? Would it result in widespread changes in the banking landscape and business models in the same way as Web 2.0 did?
I represent the thesis that Bitcoin and its underlying conceptual technology — Blockchain — may enable revolutionary changes to the banking landscape and the emergence of Digital Banking 2.0.
Blockchain
Bitcoin is a digital currency which enables instant payments to anyone, anywhere in the world. It is based on private-public key cryptography, where the owner of the private key can do transactions with his Bitcoins and where a public key allows anyone to see the amount of Bitcoins on a specific address or to send Bitcoins to this address.
The Bitcoin system is based on the Blockchain technology, which is in essence a cryptographically secured, distributed ledger. Old transactions cannot be changed and new transactions are added to the end of the distributed ledger in an unchangeable way. The integrity of the ledger is ensured by a computationally heavy process known as proof of work, which verifies transactions and is executed by a network of anonymous computer owners known as Bitcoin-miners. The Bitcoin Blockchain distributed ledger is available to anyone who participates in the Bitcoin system.
The Bitcoin Blockchain is used to track ownership and transactions between Bitcoin holders, but the Blockchain technology is not limited only to Bitcoins — any transaction with digital assets could be represented with this same Blockchain approach.
Most financial assets have digital representation and hence they could be stored in Blockchain. The transactions between the holders (addresses in Blockchain terminology) could be modelled in Blockchain, and they could be available to anyone using Blockchain technology.
Blockchain represents an innovation that could be compared in its impact to the invention of the double-entry bookkeeping system or of the legal form of doing business, a corporation. These last two innovations shaped the way we do business today. Will Blockchain be the next big invention?
Ledgers
Most of the financial industry is based on ledgers which record who owns which assets, who receives payments from these assets, and how to transfer ownership of these assets from one participant to another. But these ledgers are all private to banking institutions. This creates the need for a new ecosystem of participants whose core business is transferring ownership between asset owners.
For example: If client A sells 10 shares of IBM to client B, we see the following transactions: Client A’s custodian transfers shares and receives money, and Client B’s custodian receives shares and transfers money. The process can take up to 3 banking days and there is a middleman (clearinghouse) validating that all runs properly. The middleman will charge a fee for this service.
However, Blockchain technology allows the creation of distributed ledgers between all market participants. This results in new business models that exclude middlemen. Client A and Client B may interact directly with each other using a public distributed ledger. It is obvious that this public ledger-based approach increases the efficiency, transparency and quality of the transaction execution, and at the same time reduces its total cost.
Uses of Blockchain in traditional services
Digital Asset Registries
As I said before, most financial assets can be represented digitally: publicly traded instruments will have ISIN codes, and similar codes are being created for OTC instruments too (UTI from ISDA for example). Digitally represented assets can be stored into Blockchains, including information about who owns how much of which asset. Buy and sell transactions would be as simple as moving a specified number of digital assets from one owner to another in a cryptographically secured way. The transferor of the asset has a private key for the authorization of the transaction; the receiver of the asset has to use his private key for payment authorization. Settlement and clearing of trading transactions would be significantly simplified and speeded up by such an approach.
Portfolio Custody
If all assets of a banking client can be represented digitally, his portfolio can be completely represented by digital asset registry. A client portfolio could contain digitally represented assets and digital money (Bitcoin, Litecoin, Ethereum, etc.). The client could be able to access his portfolio from any place with his private key; he could execute transactions in his digital assets or digital money with his private key; or he can delegate management of his assets to a professional asset manager by assigning him his private key or by using a multi-signature approach in which specific transactions have to be signed by two or more private keys.
In today’s custody business model, the asset manager either has his own custody (if he is a bank) or uses the custody services of another bank. However, by using public ledger-based asset registries, the client will be the real owner of his assets. The client will not run the risk of bank failures. He will not face situations where part of his assets may be converted into bank equity (based on too big to fail provisions, when bank capital ratios are sinking below regulatory targets) or be lent out by the bank — with Blockchain, the client will be the real owner of his assets.
Collateral Management
Another business case for distributed ledgers can be collateral management in the lending process. By registering collateral in a distributed ledger and by specifying for whom and how long the collateral is allocated, we create an effective means of collateral management. The speed of collateral management will be increased, the traceability will be available and transparency for regulatory reporting will be created. Additionally, collateral margin calculation would be simplified as it would become transparent how many times specific collateral is already lent out.
These were some examples of the potential uses of distributed ledgers. One can assume that there will be as many new potential uses of distributed ledgers as there are ledgers today.
New applications for the new technology
Smart Contracts
Blockchain technology also allows for the implementation of “Smart Contracts” where assets are exchanged on certain conditions against payments. Let’s look again at the example “asset in exchange of payment”. If we have a digital asset which represents an IBM share and if we have a digital means of payment (Bitcoin), then the exchange between Client A and Client B can be executed in one transaction. This new transaction will be added to the Blockchain, it will be cryptographically signed and there will be no way to change it after that. There will be no need for complex 3-banking-days long business processes — everything can be completed within 10 minutes.
This is an example of a basic smart contract. The business logic of a smart contract can be extended in arbitrary ways: there can be multiple participants, there can be escrow services, multiple payment terms, etc. These will be digitally executable contracts between digital assets and digital money. All derivative, future or bond contracts could be represented as smart contracts so that their processing can be 100% automated.
Private and Public Ledgers
Bitcoin Blockchain is a public ledger and thus is available to any member of a Bitcoin system. Asset registries and transactions between holders of these assets on Bitcoin Blockchain are visible to anyone too. Public ledgers do not have any gatekeepers defining who can or cannot participate.
At the same time, there are several technology providers offering Private Blockchains. These are “mini-Bitcoin” systems, where only the participants of the private blockchains can transact with each other. These Private Blockchains can be use-case specific or participant specific — for example private collateral management blockchains for big banks. Private Blockchains would work on the basis of permission, namely there would still be a central instance which will grant or remove memberships to respective blockchains. These gatekeepers would thus have a potential revenue source or even provide new business models.
Emergence of New Service Providers
Every bank has either built or bought their “ledger” systems for managing huge numbers of standardized digital transactions. Middlemen are facilitating the ownership and flows of funds between banks. Both these bank “ledger” systems and middlemen are becoming obsolete.
Both services can be taken over by public or private Blockchain ledgers from new service providers. One bank probably does not want to become a member of another bank’s private Blockchain ledger, where the other bank is gatekeeper to the service. However, the same bank could be ready to become a member of a private Blockchain of an independent service provider. The private Blockchain would have a higher utility as more participants join, which would attract new participants and so on. It’s the same network effect which is core for e-Bay or Facebook business models.
This creates room for new market participants whose core business will be running today’s diverse banking ledgers. The businesses of these new service providers will benefit strongly from network effects however, which will likely lead to the consolidation of these new service providers.
Investments into Bitcoin / Blockchain Sphere
By September 2015 venture capital investments into Bitcoins were USD 921 mio; the number of venture capital-backed startups was 119 and the Bitcoin sector became the fastest growing startup sector. Investments into Bitcoin companies in 2014 and 2015 match investments into early internet companies in 1994 and 1995. Blockchain and Hybrid startups have received USD 285 mio in investments, representing 22% of startups in the Bitcoin sphere.
Additionally, there are a number of big banks experimenting with Blockchain technologies, whose main focus is how to use decentralized ledgers in banking business processes.
Bitcoin may have caused people to overlook the potential of its underlying technology, but based on venture capital investments and on experiments in the major banks, we can say for sure that the Blockchain technology is here to stay.
Conclusions
Digital Banking 2.0, based on Bitcoin and Blockchain technology, will result in revolutionary changes in banking. The role of current players in the ecosystem will change and new players will emerge. Many current services will be provided at a much lower cost basis. Middlemen will lose their positions in value chains in the same way it happened in the music industry about 15 years ago. This will translate into changes in banks’ revenue models, which, together with the entrance of new participants to the market, will trigger changes in business models, and result in complete banking ecosystem changes.
The transactional part of the banking business will change as well. Many of the complexities of ledgers, asset transfers and collateral management will be simplified, and banks will be able to decrease headcount. Transaction management will become a commodity in the banking business.
However, the advisory process, portfolio management, credit management and risk management — the know-how intensive disciplines of modern banking — will stay. Banks will simply focus more on their core competencies and less on transaction processing. This will result in an increased focus on know-how intensive areas, which at the end means real value creation for clients.
(This article was first published in Swiss CFA Society Magazine 2015 November Edition)
The traditional banking business is based on fiat currencies. Conversely, a diverse range of cryptographically secured digital coins underlie the cryptoasset industry. In previous articles, we looked at how traditional...
The
traditional banking business is based on fiat currencies. Conversely, a
diverse range of cryptographically secured digital coins underlie the
cryptoasset industry. In previous articles, we looked at how traditional
banking revenues will be intermediated with blockchain technologies and
how the key banking processes will be impacted by blockchain
disintermediation.
Now let’s consider the big question: How will traditional banking react to emerging crypto finance?
Strategic choices
Four response strategies are possible and this article will explore these options in greater detail:
· Do nothing — continue to run business without adjusting course
· Wait and see — monitor the situation on an ongoing basis and develop internal capabilities
· Gradual integration — try to selectively integrate crypto-finance products into traditional banking
· All-in commitment to crypto finance — shift fully to crypto finance
These strategies can be positioned on a product offering/capability matrix as follows. Here, the product offering dimension describes how advanced the crypto-product offering is, while the capability dimension indicates the degree to which advanced crypto-finance capabilities have been developed and are available to the banking organization:
This article will explore each of these strategies in further depth.
Strategy 1: Do nothing
This
strategy involves taking no action at all. Essentially, it represents
the delegation of decision-making on an active response strategy to a
point in time in the future.
This response strategy can be considered in relation to the client base of a given traditional bank:
· For private banking, i.e. the wealth management
branch of traditional banking, most clients are found in the 50+ age
group. All private banks have online banking channels, but usually less
than a third of the client base are actually using these online
channels. Obviously, it could be difficult to explain the benefits of
crypto products to technology-adverse clients, which in turn would
result in this strategy choice.
· However, retail banking
is different . This branch of banking serves everyday needs ; it’s
about payments, credit cards and small loans . These are the financial
services that 95 percent of people regularly use. The retail client
segment also has a greater affinity with technology. For this reason, it
is possible to explain to them the benefits of crypto finance ,
including inexpensive and fast cross-border payments in the remittances
use case.
This
is also associated with a “copycat” strategy . Sometimes it can be a
good idea to let other banks make the first moves — to become the
pioneers and also to make costly mistakes. This would allow others to
learn from their mistakes and imitate successful strategies.
Nonetheless, the total market capitalization of cryptoassets is
approaching USD 150 billion; this market cannot remain ignored for much
longer.
Strategy 2: Wait and see
An
extension of the “do nothing” strategy would be the “wait and see”
strategy. This entails monitoring the market, analyzing competitors’
strategies and incrementally developing the internal know-how.
This
offers a strategic option for traditional banks. If cryptocurrency
adoption increases and if clients’ demand for crypto products grows,
then a crypto offering can be developed on existing internal
capabilities.
Implementing
new products in traditional banking is relatively complicated and
costly. However, if initial frameworks are already in place in
traditional banks, this will result in smoother implementation.
Strategy 3: Gradual integration
Bridging the gap between the fiat and crypto world and developing these two sectors in concert is key to this strategy.
According
to this strategy, crypto products are gradually integrated into the
existing offering of respective banks. For instance, this could start
with the following simple products:
· The topic of remittances
is often discussed, but thus far this service has not been supported by
traditional banks. The “cannibalization” of respective strategies is
one reason for this. However, offering remittance products would enable
banks to include additional client segments as well as profit from
additional offerings beyond this segment, for example through credit
card revenues.
· International fiat-crypto proxy accounts
could be useful products for international companies. International
companies need international banking accounts, but transferring funds
between these accounts takes time and incurs considerable costs. These
transfers could be accelerated while reducing the associated costs by
using fiat-crypto proxies.
· Another example of possible products includes smart contract-based lending
. Banks would earn revenue from the usual interest rate, but the
additional margin on top of this interest rate would be almost zero,
since the operating costs of this form of lending would be eliminated.
Corporate clients who use this lending facility, would benefit from
lower interest rates than usual (due to the eliminated margin).
· Investments products
like funds for cryptoassets are also conceivable. Due to the fact that
cryptoassets exhibit valuable performance characteristics as well as
valuable volatility characteristics, they would represent a useful
addition to the alternative assets category within client portfolios.
Examples of this strategy include:
· SwissQuote,
a Swiss bank, is cooperating with the fiat/cryptocurrency exchange
Bitstamp in order to offer its clients the possibility to trade directly
with Bitcoin.
· Falcon Private Bank, likewise a Swiss bank, offers to its wealth management clients the possibility to invest in Bitcoin products.
So
far, these are the first two examples in Switzerland — in a country
with around 250+ regulated banks. We assume that additional banks will
follow suit.
On
the one hand, the banks are able to present themselves as innovative
and, on the other, they offer meaningful products to their clients,
which also generate revenue for the banks. Banks can develop their
internal capabilities for crypto-product offerings and achieve quite a
competitive advantage in the process.
Strategy 4: All-in commitment to crypto finance
This
would imply dropping traditional banking and converting the bank into a
fully fledged crypto institution that would offer the following
products:
· Payments (already available in crypto finance)
· Custody (already available in crypto finance)
· Credit cards (already available in crypto finance)
· Lending (not yet fully established in crypto finance)
· Wealth management (not yet available in crypto finance)
At
present, this strategy might be challenging for traditional banks,
especially in view of their current client base. Around 99 percent of
clients do not own any cryptoassets and those who do own cryptoassets
would rather not go through the traditional banking system.
However,
since several key cornerstones of traditional banking are already
available in crypto finance, we can anticipate that solutions for
remaining areas will also be developed, which in turn would enable this
“all-in” strategy.
Summary
The distribution of these strategies are currently as follows:
· Most financial institutions are currently pursuing the “do nothing” strategy
· A limited number of institutions are applying the “wait and see” strategy
· A very small number of institutions are following the “gradual integration” strategy
· The “all-in commitment to crypto finance” strategy cannot be observed currently
We can anticipate the following strategic moves towards increasing blockchain capabilities in traditional banking:
· Progression from the “do nothing” strategy to the “wait and see” strategy
· Progression from the “wait and see” strategy to the “gradual integration” strategy
It will probably take a while until the “all-in commitment to crypto finance” strategy is implemented . The main factor for this will be the mass adoption of cryptoassets. However, if this strategy is implemented, we will see the increasing erosion of traditional banking revenue.
Many banks are participating in a range of blockchain consortia and are looking for ways to apply blockchain technologies to improve their internal processing. Here, the approach is to essentially...
Many banks are participating in a range of blockchain consortia and are looking for ways to apply blockchain technologies to improve their internal processing. Here, the approach is to essentially carry on “business as usual” but achieve efficiency gains. Banks are able to increase their effectiveness with the help of blockchain technologies.
However, the change in ecosystems will not only facilitate improvements to internal processes. It also means that clients will receive blockchain-based service alternatives and require fewer traditional banking services for their value networks.
In current value networks, clients have very much been tied to their banks. The cost of changing a banking relationship is relatively high, and this has made it quite easy for banks to generate revenue. The changes facing value networks will significantly reduce exit costs for clients, while the cost models of banks will become more transparent. Clients will be able to switch easily between financial services providers and select the best fit for their needs.
The following figure visualizes this change to value networks. As discussed , banks clearly lie in the center of clients’ value networks at present. But as alternative blockchain-based services emerge, clients will start to use these alternatives, thereby reducing their dependency on banks.
This result in revenue decline of the banks. But how big is this impact and what will be timeline of this impact?
This analysis looks on:
· How banks are generating revenues at the moment?
· How blockchain based business models will disintermediate banking revenues?
· What will be the timeline of this transformation?
How do banks generate revenue currently?
Let us evaluate the key components of banking revenue based on the Swiss unit of Credit Suisse. This division encompasses retail banking (for clients domiciled in Switzerland), private banking (wealth management), and commercial banking (one third of companies in Switzerland maintain a banking relationship with Credit Suisse).
The revenue figures are publicly available in the investor section of the Credit Suisse website. Here are the revenues for the first quarter of 2017:
The key components of banking revenue are as follows:
· Net interest income
· Recurring commissions and fees
· Transaction revenues
Net Interest Income
This refers to the revenue from money lending. At this point, we will not discuss the degree to which banks lend depositors’ funds or create new money during the lending process. However, we can assume that approximately 97 percent of electronic money in Switzerland is created by commercial banks during the lending process; the other 3 percent is created by the Swiss Central Bank.
Lending incurs a cost to banks ; reserve ratios have to be applied, parts of loans have to be covered by core capital and/or high-grade capital instruments, high-grade financial instruments and so on. These guidelines are defined by the regulator and are binding for the banks. Thus, although banks create money in the lending process, this money creation is not free for the banks . There are costs associated with lending money which are determined by banking regulations and capital markets.
Now let us return to net interest income: It comprises the difference between the price of money which the clients pay and the cost of lending. This is the category in which banks generate most of their revenues (assuming client risks are properly assessed). If the economy is booming, there is more money creation and more revenue in this category. In the event of an economic slump, the reverse is true.
Recurring commissions and fees
These concern the revenues raised from custodial accounts, banking packages as well as portfolio management fees. Banks love recurring revenue, following the idea of “sell once, collect revenue over many years”. As the exit costs for clients are relatively high, clients are locked in, thereby providing a stable stream of revenue for banks with relatively low maintenance costs.
Transaction revenues
Transaction revenues refer to payment fees, fees for buying and selling shares, mutual funds and ETFs. Essentially, these fees are connected with either the business or investment activity of bank clients.
Revenue disintermediation through blockchain business models
Net interest income will be substituted by smart contracts. In this scenario, clients would not need a bank . Lending would be conducted using automated lending facilities. However, some lending is performed on the basis of advice , and this advice-based revenue will remain available to banks. Nonetheless, this would only account for a small part of net interest income. We estimate a conservative level of around 50-percent revenue disintermediation in this respect.
In the case of recurring services, clients will hold their assets as digital tokens on blockchains, rather than in custodial bank accounts. Banking packages will not be required, as they will be replaced with blockchain-based products (the cost of which is close to zero). Only advice-based services will continue to generate revenue for the banks. In this context, our conservative estimate is a degree of revenue disintermediation amounting to two thirds.
Transaction revenues for payments and trading will reduce significantly . Clients will no longer need banks for these services. However, advice-based fees for complex transactions will remain unaffected. But again , this only represents a small part of current transaction revenues. Here, we conservatively estimate a degree of revenue disintermediation of around two thirds.
It is clear that advice-based services will remain intact. Most other services, however, could be replaced with blockchain-based smart contracts or digital tokens. The disintermediation impact is shown in the following table:
Timeframe for the impact of blockchain on banking revenue
The timeframe of the change in value network can be expressed using an S-curve. JPMorgan published an S-curve in its assessment, which can be used as a basis for the analysis here.
The next three years will be used to establish and develop shared infrastructure (i.e. service-specific blockchain offers). The mass adoption of these new services will start after three years and this is also when the disintermediation of banking revenue will commence.
Transaction revenues: impact in 3–5 years.
This revenue position will be the first to be impacted by blockchain technologies. Transaction revenues are currently collected as payment fees or fees for trading securities ; this will be disintermediated by blockchain-based solutions.
Recurring commissions and fees: impact in 4–6 years.
Infrastructure development could require more time here. For example, in the case of custodial services, we will also need the digital representation of financial assets.
Net interest income: impact in 4–6 years.
In this context, we need digital asset infrastructure as well as smart contract-based solutions for debt products.
Conclusions
Banks are currently focusing on using blockchains in order to improve internal processes. However, as blockchains will enable changes to client value networks, banks will have to prepare to lose significant portions of their revenue to new blockchain-based financial services providers.
The following table shows the expected disintermediation impact and associated timeframe using the example of the Credit Suisse banking unit in Switzerland:
Banks will begin to lose revenue on basic transactions. Most of these services will be free, almost free or subject to significantly lower service fees. Advice-based services will remain within the purview of banks; this includes portfolio management, risk management, and the management of special transactions and products. Indeed, these concern services where specialist expertise is required, and banks will still be required to offer them in the future.
Blockchain technology will bring about changes to client value networks: New alternative financial services providers will emerge, and services that are currently billable will become free or virtually free (including...
Blockchain technology will bring about changes to client value networks:
New alternative financial services providers will emerge, and services that are currently billable will become free or virtually free (including payments, custodial accounts, etc.).
The relatively high costs for clients to switch banks will reduce significantly. Clients will be able to engage in “service hopping” when searching for the services that best suit their needs.
This article looks at the key processes of private banking and considers how they will be impacted by blockchain. We can categorize these processes as follows:
Client-facing processes, which are highly relevant; these are value-adding processes for the client and revenue-generating processes for the bank.
Supporting processes, which outnumber client-facing processes by one or two orders of magnitude.
Compliance and regulatory processes, which do not directly add value for the client or the bank, but represent a requirement.
Key banking processes
In the following table, key banking processes are divided into the “1st level Category” and the “2nd Level Category”:
Process list
Client opening processes — these processes are related to opening new client relationships. It encompasses KYC (Know Your Client) and establishing who is the beneficial owner or the real owner of the assets.
Client opening also covers product opening processes. Different products require different setup parameters from the client. For example, when ordering a credit card, you can specify whether it is “silver”, “gold” or “platinum” and whether there a need for a partner credit card (with corresponding fees).
Some products might not be allowed in some jurisdictions (determined by the client’s domicile) or, for example, US persons may be excluded from the offer (regardless of jurisdiction).
Client compliance processes — there is a high level of client activity monitoring that takes place in modern banking; most of this is determined by regulations, but not exclusively. For instance, if a bank has given a mortgage to a client who then decides to transfer assets out of the bank, the client would quickly receive a phone call from their relationship manager.
But this also relates to flow-of-funds analysis (if clients make larger payments, they might need to add additional justification for these payments) or AML-related (Anti-Money Laundering) issues. Regulatory client reporting, such as FATCA, AEI, withholding tax, MIFID, etc., also fall under the same category.
Client tax reporting is likewise covered by this category. Clients are provided tax documents that are required each year. If a client decides not to submit these documents to the relevant tax authorities, the tax authorities will still obtain digital access to these documents via the AEI (Automated Exchange of Information).
Client profile updates are also relevant here. This concerns keeping client profiles up to date (regarding domicile, nationality, etc.), as this information determines which products can be offered to which clients. Indeed, it can also determine that certain clients cannot be contacted actively at all, for example, if they are offshore clients in certain domiciles.
Sales management processes — this involves a lot of client profitability analysis (which is always running in the background) or client potential analysis (which is about identifying additional suitable products for specific clients). These processes are intended to identify which customers are “good” and which products may be sold to these customers.
Banks earn their revenue by selling financial products to clients; banks are not altruistic organizations that seek to serve the common good in society. They want to sell, sell, sell. And there are also fee structures that are not always transparent (one could speculate that this is deliberate).
Of course, there are product suitability processes in place. Lehman Brothers structured notes (a global financial services provider that declared bankruptcy after the Lehman Brothers default) are not suitable for grandmothers, for example. Advisory risk processes would also not allow a 100-percent portfolio allocation in structured notes (which would be subordinated claims, if the issuer went bust).
Client reporting processes are likewise included here. They provide clients with helpful summaries about transactions or the investment performance of their assets.
Client transaction processes — these mainly relate to payments and client trading.
Portfolio management processes — here we have a full stack of processes starting from creating the Investment Policy Statement (IPS) and ending with the client portfolio review with the client.
Every client has an IPS which is determined by their ability to take investment risk, their willingness to take investment risk and the constraints issued by the client (for example, no investments in the tobacco sector). All investments should always be made in accordance with the IPS.
Each bank defines the strategic asset allocation (the range of assets that should be invested into specific asset classes) and the tactical asset allocation (which is a more short-term form of asset allocation). This is usually performed by research departments.
This process category is advice-intensive. And this advice is and will continue to be, the core competence of banking.
Credit processes — this category refers to lending and the associated monitoring of risks. This is the process category in which banks generate most of their revenue.
The key process here is the client credit risk calculation. This risk determines the loan interest rate. It is dictated by client income, other obligations, the amount to lend, family circumstances, and other factors.
Another key process is credit payback monitoring: Is the client still able to repay the loan and are any adjustments required? If the client is unable to pay back the loan, the client default handling process is initiated.
Client closing processes — the costs for clients to switch banks are relatively high in the traditional banking system. If a client changes their banking relationship, it is necessary to transfer their assets to another bank. This is a costly process that also takes a lot of time.
The impact of disintermediation on processes
In the previous article, we looked at how private banks generate revenue and how this would be impacted by blockchain disintermediation:
Client transaction processes would be based on various distributed ledgers and would essentially become free for clients.
Credit processes would be conducted using smart contracts, which would result in low-cost execution for clients and the loss of a revenue source for banks. However, advice-intensive lending products would remain unaffected.
Portfolio management processes are relatively advice-intensive and they would also remain unchanged.
But let us consider client opening, client compliance, and client closing — since the client would be in control of their own assets and their switching costs for blockchain-based assets would be minimal, clients will be much less tied to banks than they are currently. This will bring major changes to this process category.
Client assets would not be listed on the banks’ books like they are today. Client assets would be controlled by the respective private keys and secured on the corresponding crypto-asset blockchains. If a client needs portfolio management from a bank, in the future they could set up 1:2 multi-signature access (signature one for the client and signature two for the bank) for the asset manager.
Sales management processes will likewise transform due to the following:
Barriers for clients would be very low (and banks would no longer be able to lock in their clients for the long term). This would result in clients being able to select the best products for them.
Many products that are currently rather costly will become either free or subject to very low fees, and it would make no sense to sell these products to clients.
The client profitability analysis and client potential analysis will no longer be as important as they were before since banks would no longer be able to tie in their clients for a long time.
Timeline
The key question here is how exactly will the timeline of blockchain disintermediation unfold.
Technology adoption can be expressed using an S-curve comprising the following adoption phases:
Innovators — 2.5%
Early adopters — 13.5%
Early majority — 34%
Late majority — 34%
Laggards — 16%
We would probably not be inaccurate to assume that less than one percent of the working population in OECD countries currently own any cryptocurrencies — this comes under the “Innovators’ Phase”. Real business value will develop from the middle of the “Early Adopters’ Phase” — from an adoption rate of ten percent.
It is difficult to forecast when an adoption rate of ten percent will be achieved, but we could estimate a time frame of three to five years. This adoption will not only involve “owning tokens” but also “value-adding business services”, including banking, meaning there is a real impact on banking processes and banking revenues.
Summary
This analysis can be summarized in the following table:
Blockchain disintermediation will affect key banking processes, such as client transactions, portfolio management, and credit processes. They are all among the key processes in which banks generate revenue today.
On the one hand, there will be huge opportunities for crypto/fintech companies to focus on these areas. On the other hand, traditional banks will have to seriously rethink their future processes and revenue streams.
My friends, myself and my brother published book Blockchain Technology: Einführung für Business- und IT Manager Blockchain Technology - Einführung für Business- und IT Manager OK, it’s in German. However, it’s...
Blockchain Technology – Einführung für Business- und IT Manager
OK, it’s in German. However, it’s very praxis oriented and follows always the thought about what is business value and what business models we will have.
Video of the first book presentation is available here. I’m starting to talk at 18:28, my brother follows immediately to me.
If you have more time to watch, then we had here as well very nice presentation about Hyperledger and discussion about Ethereum Classics versus Ethereum.
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